Macroeconomic and financial market commentary

What makes Yellen so confident in her ability to tighten without disruption?

The latest fad in CentralBankville is market manipulation. It has been the inescapable follow up to a long string of increasingly stimulative monetary policies. Easy money can be traced all the way back to the maestro’s nomination. He began with low rates, then came QE (BOE), even more QE (FED), please take it up to extreme QE (ECB, BOJ), introduce negative nominal rates (Riksbank), then profoundly negative rates (SNB), add some yield curve control (BOJ), and all while increasingly tilting towards “forward guidance” policies. Outright manipulation was, in retrospect, the next obvious step in the Central Bank’s conspicuous seizure of power in the global village.

Why do I say manipulation? Because it is clear to me that the only difference between intervention and manipulation is communication. CB’s have been increasing their market intervention for the last two decades. So far so good, even if I doubt it’s a healthy habit if we want to continue to pretend that markets ensure the optimum allocation of resources. But post the GFC, and led by Bernanke, they have increasingly switched over to price manipulation.

Only the BOJ continues to intervene in the open as opposed to manipulating. If they want to keep the long bond yield low, they tell market players to expect unlimited buying by the BOJ at a certain level. If they want to support equities, they go on the tape to affirm they are buying ETFs. The rest, with a special mention for Bernanke (reluctantly, his successor as well), and Draghi, have fully embraced the dark side of the force.

Sure enough, manipulation is now a methodology applied regularly at most Central Banks. It gives them a feeling of control, and they are in control! They are pleased with their success. It does help to keep other players in the dark and confuse them with price and volume signals that they perceive as market generated -when they are in fact CB cooked.

All clear then? Nope. In the long run, it ain’t going to cut it either. Manipulation has never been a viable long term strategy, and this time is not different. Manipulation is only feasible at critical turning points, in a context of very easy money. At some point, when easy money ebbs, manipulation will fail, and it is hardly reassuring to see that Yellen is oblivious to the fate that awaits us.

Undisputably though, manipulation is working, for now, therefore helping Yellen, Draghi, Kuroda, and Co feel safe. It is a foolproof medium term strategy -when simultaneously implemented by coordinated Central Banks in the right liquidity environment. And it can wreak havoc within the ranks of the dissidents. Let me disclose that I got severely hit by the surreptitious short squeeze in European Banks post the Italian and Spanish bank bankruptcies of the month of June. I had a very strong short in the Euro Stoxx bank index and was stopped out two weeks ago for the second time in a row this year.

In truth, nothing new under the sun. Preemptive strikes against the possible generation of negative momentum in any of the financial or economic variables they target had already become the norm. I knew they did that in the Eurex market for sovereign bond spreads -but was unaware of the extended scope of their manipulative interventions. They manipulate not only rates but also equities, gold or even commodities when required -with timely and stealthy interventions. Even bank share prices are a target now! POMO desks are all over the place and preemptively strike against possible systemic risks when denoted by price moves of critical assets.

They do it for a substantial reason. Interventions are suddenly not enough if investors are aware of them. They would point their finger at inconsistencies in pricing. So CBs come up with a plausible narrative for a forced market move -and make sure it is attributed to market forces. In this way, they manipulate the variables that they think are essential to generate a guide for investors. They use market price manipulation to induce momentum following thus guiding investors in the “right”, extend and pretend direction. Press narratives make me laugh heartily.

I am near certain that coordinated manipulation is one of the taboo (nobody dares touch the subject) causes of the low VIX numbers. Low realized volatility influences implied volatility in the pricing structure -if sustained long enough. Of late implied volatility, however low, is still above realized volatility! Not to mention the most likely direct manipulation of the VIX that takes place when required. Pavlovian instincts are alive and well, and investors respond instantly to guidance and its enforcement by POMO desks when needed. Manipulated, powerful market moves show the way. The quest for yield ensures the crowd’s approval. Think on your own at your peril. I can attest to that.

I have no doubts that monetary largesse warrants the long term bullish bias in equity markets, but, regardless of the underlying trend, I have never seen a succession of bullish turnarounds (against all technicals) in such reiterated, almost standard fashion. Some major, vertical turnarounds take place when the volume and price activity have signaled a strong down move in most of the time frames. I have been trading global markets for a long, long time; I know what I am talking about! POMO desks prevent any breaks before they could near a systemic risk qualification. BTFDippers are happy to cooperate. ETFs do not leave the party. Stop busting and “fear of missing out” finish the job. POMOs end up making lots of money. Our money. It is a criminal conduct.

Manipulation is also the ultimate cause for the ridiculous pricing of Euro zone banks. I stumbled into a new widow-maker trade and was inevitably stopped out. Not that the situation for European Bank shareholders is not dire. Most of their shares are held by customers that have been told that what they are holding is a near risk-free product. It is vital that they remain oblivious to the risks of their holdings or else an investor stampede would ensue. The ECB can not afford that to happen. Mario is doing whatever it takes once again. I understand the ECB’s concern, but the end never justifies the means.

It is not manipulation that provides the overall bullish impulse. Liquidity and the quest for yield take care of that. Both provide the necessary bullish support for the success of manipulative activity that surged post the first 1Q2016 financial market scare. But even in a bullish market, we should have ups and downs; not everybody is that complacent. The problem is no “downs” are allowed to happen. The Yellen put is “at the money” and is permanently rolled over regardless of the price. Precluding a tsunami of ETF outflows is paramount. Bearish headlines must be avoided at all costs.

It doesn’t cost them money (they make it back from other players while manipulating prices), and they play the game in size. CB balance sheets have infinite elasticity when needed. With the additional help of ETF induced reduction in the total price-sensitive free float, their interventions are more and more meaningful. CBs are now firmly in control of the downside. They even think there will never be another financial crisis in our lifetime -forgetting the need for incrementally accommodative monetary policy to keep things stable. Yellen’s assuredness is eerily reminiscent of Keynes’ assertion of confidence back in 1927.

Pity the upside is another matter and has them worried enough. You cannot control everything -fooling everybody all the time. By now investors are exultant and play happily to the BTFD script -but refuse to take a more cautious stance in their asset allocation. Central Bankers are surprised by market froth. They completely forgot that it is always difficult to put the genie back in the bottle -particularly if you suppress downside risk for years.

As for their increasingly erratic guidance, the truth is they have us all confused -and their reputation is further tarnished by recent events showing that they have lost control of the upside in equities and High Yield. As the bubble soars, macro managers and global strategists are all at a loss when trying to understand Janet Yellen’s latest flip-flopped statements. Consequently, we have all been whipsawed to some extent (that is, of course, unless someone has played by the rules and stuck to a long only, trust the Fed, investment strategy). It is my worst year ever.

How do you blend the following Yellen conceptual contradictory statements into a coherent narrative? Let’s synthesize a couple of them:

We will probably never have another financial crisis in our lifetimes. Has she joined the Irving Fisher- John Maynard Keynes school of predictions?

QT (quantitative tightening) will be a peaceful process. Something akin to watching the paint dry. Wow! Best wishful thinking in town.

Weakness in economic growth and inflation figures is only transitory and should not affect the interest rate hike calendar or the QT schedule. Of late, she has tempered that view.

Valuations are probably on the high side and implicitly allowing for some “minor” financial stability concerns. Only on the high side? Really?

The QT process should start relatively soon (meaning September in Fed-speak). Got you, Janet. But is it going to last? Will it be market dependent?

The Wicksellian rate of interest is very near current levels and (implicitly) requires few additional rate hikes. Good guess! Sure of that or the precise NAIRU level as well?

Believe it or not, she said all of that in the last two months. When trying to make sense of it, I feel like I am working to decipher Egyptian hieroglyphs. Finally, I think I have a comprehensive view that fits it all in nicely. Let me explain is what I think she and the core members of the FOMC mean:

We have had low or nonexistent interest rates for too long, and side effects are killing us. We want out of the NIRP and ZIRP business asap. We also need a cushion to use in the next recession when it inevitably comes. Some of us (Yellen and Fisher) would also love to leave positive real interest rates without a market bust before we quit (next year). Oh my God, please help us out of this corner we have painted ourselves into. Low rates cannot go on forever!

Because I cannot even hint at admitting the detrimental side effects of low rates (Yellen), I have to base rate increases in perceived economic strength, and I have to sell the idea that the economy is doing fine -regardless of the disappointing figures in the data from March onwards. Whenever I see strength ain’t good enough and lose confidence in the ability to raise rates repeatedly without real or financial economy disruption, I will come back to being concerned not about a recession but about not having enough inflation. What worries me (Yellen) though, is being able to get out of low rates, and stop the bubble without bursting it -or collapsing the economy.

We are terribly scared about equity valuations, high yield spreads, VIX levels, commercial estate valuations and perspectives, unstoppable stock markets worldwide, house price levels and lease prices. We are aware of the risks involved where we sit now. But we cannot voice our concerns -or talk bubbles even in conditional mode.

We think taking out some excess reserves (QT) might be more useful to stop the bubble than some additional rate hikes. And probably also less disruptive to the real economy. The financial bubble is the problem, but we can always pull back if we see too many cracks. We will adapt QT as it goes, if needed, monitoring markets carefully. We will engage in market manipulation when necessary, and feel confident we have done well at that in the past. On a positive note, we are comforted by the fact that the real economy is unlikely to be affected by QT (it wasn’t directly affected by QE either) unless something breaks in the financial world. Manipulative guidance should help make sure QT is an orderly process.

The potential growth of the economy has been severely hampered by the demographic and productivity trends (of course they do not think they have also contributed to lower our growth potential). Debt levels are breathtaking: no way we can raise rates that much more. The rate level we can achieve is not high enough to stop the bubble. We have no alternative but to take some chips (sorry, money) of the table. At this stage, QT is a must do.

A strong dollar is not as good as it seems (Trump) but a very weak USD doesn’t help either. We need tighter financial conditions in the least disruptive manner. No interest in a weaker dollar anymore (but let’s make sure The Donald doesn’t get to know this). At some point though we will have to make a stand. Where?

Where do we go from here?

I think they are trying to take money out of the system and raise rates. CBs are now aware of the need to end easy money, or as they put it, normalize monetary policy. They will decrease stimulus as rapidly as they dare to, but keep an eye on both financial markets and the underlying economy.

If the markets or the economy tank, they will cease tightening, or even reverse course. It is too late in the game to change their strategy -however wrong they are beginning to understand it is. If only the market falls, manipulation and more base money or credit will most likely contain the damage. But if it is the economy that takes a nose dive all bets are off.

Success at market manipulation makes them confident that they can handle market volatility and prevent any serious downside. They know ETF volume is dumb money that will only sell if frightened enough to do so. They will try to break asset bubble dynamics, get rates up a little bit higher, and make sure that they do not induce a market event or a recession.

The real economy is the variable they do not control entirely. Printing and pushing credit aggregates has helped the economy short term but they haven’t fixed anything structural. They know it. Every new massive intervention has added a new layer to the global debt overhang. Debt matters and at some point, it will sink the ship. The real economy will be the final arbiter of our fate.

Accordingly, I think we have to wait for an end of this artificially extended business cycle and sell only on real economic weakness. Financial market weakness will be aborted quickly with the same recipes they are using now. If this is a financial play, the game is rigged in their favor. More money and credit and lots of coordinated manipulation in a context of a mass of investors starved for yield make their success a sure thing.

I will take advantage of the time in between to lick my wounds and wait for the kill. Until the real economy breaks, they are the dark side of the force and still in control. I have learned that lesson the hard way. In the end, the real economy will implode crushed by the debt pile, the disastrous aggregate demand (inequality and wages will impede any improvement there), and the revolt of the have-nots. It is only a matter of time.

Timing is always the problem. Growth keeps slowing, and it is an ongoing process once the brutal 2016 stimulus has worn off. Only the BOJ and the ECB continue to prime the pump. But we should not expect financial markets to front run that event. Rather, capital markets might be late to react to a deteriorating real economy because it will take a severe jolt in confidence to erase the Pavlovian mentality now embedded into most fund managers.

I have been too greedy, and CB’s found my back. I’m short of ammo now, and I have to make the next/my last shot at shorting this bubble, count. In the meantime, I am standing aside and bidding my time, as I remind myself that this summer of 2017 is irreplaceable -and I can already feel it slipping through my fingers. Let’s make the best of it while we wait for the CB orchestrated financial genocide, to take place.